March 16, 2020 Update:
The Ides of March brought considerable changes to the Federal Reserve’s strategy to provide stability during the Coronavirus outbreak:
- The Federal Funds Rate was given an emergency 1% cut, placing the upper limit of the target range at 0.25% and the lower bound at 0%. This comes after a previous 50 basis point rate cut two weeks ago.
- The Fed will now be purchasing at least $500 billion of Treasury securities and $200 billion of agency Mortgage Backed Securities, up from the pledged $60 billion last Thursday. For perspective:
- QE1: November 25, 2008 – Fed pledged to purchase up to $600 billion in agency MBS. Four months later, on March 18, 2009, the Fed announced additional purchases totaling $750 billion of MBS and $300 billion of Treasury security purchases.
- QE2: November 3, 2010 – Fed announces $600 billion of long-dated Treasury securities.
- QE3: December 12, 2012 – Fed announces purchases of up to $40 billion of MBS and $45 billion of Treasury securities, monthly, with no end date. Program began tapering off in December 2013, finally concluding in October 2014.
- QE4: Currently taking place. $700 billion authorized of Treasury and MBS purchases… so far. $40 billion of nominal Treasury coupons and TIPS, and $80 billion of MBS was set to be purchased today.
- An additional $500 billion of overnight repo has been offered both today and tomorrow. All previously scheduled repo offerings remain unchanged.
- Reserve Requirements, the amount of money banks must hold onto (unable to lend) while making loans, were dropped to 0% (effective March 26, 2020). Previously this number ranged from 3%-10% based on transaction size and other considerations.
- International coordination between the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Swiss National Bank, and the Federal Reserve to lower the cost of exchanging US Dollars via standing swap lines by 25 basis points.
The Federal Reserve is making a huge effort to alleviate potential funding pressures. A tremendous amount of money has been made available, intended to keep the lending markets operating smoothly in this volatile time.
From March 12, 2020:
Fed Elevates Repo Operations to Counter Treasury Market Disruptions
By Logan Robertson and Thomas J. Connelly, CFA, CFP®
Over the past couple weeks, uncertainty surrounding the coronavirus outbreak has driven equity market prices sharply downward, bond yields to all-time lows, and has launched implied volatility to highs unseen since the 2007 to 2008 Global Financial Crisis. As companies around the world plan for possible coronavirus business impacts, coupled with large flows away from risky assets, it appears the Federal Reserve is fearful of significant disruptions to financing markets that could impede liquidity in some trading markets.
Yesterday, the Fed announced a massive plan to boost both repo (repurchase agreements)* operations and security purchases. This decision was made to “address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak.”
- $60 billion of outright purchases of Treasury bills, coupons, inflation-protected securities, floating-rate notes, and more
- $1 trillion of three-month repo offered over today and tomorrow ($500 billion offered weekly for the next month)
- $500 billion of one-month repo offered tomorrow ($500 billion offered weekly for the next month)
Additionally, repo operations already in place will continue:
- $175 billion of daily overnight repo
- $45 billion of two-week repo offered twice per week
It is currently unknown what extent the market will take up the Fed on their offer, but the money is there if liquidity issues arise. Only time will tell.
*Repurchase agreements are a crucial part of the short-term funding markets. A repo transaction involves a sale of some security (normally US Treasuries) in exchange for cash, with an obligation to then repurchase the same security back from the cash-lender, at some premium. Repo is a short-term funding source, ranging from one-day (O/N – overnight) to several months (term). Cash-borrowers benefit from the transaction by being able to turn assets they hold into cash for funding or leverage needs at a relatively low cost. Cash-lenders benefit by being able to collect a rate of return on unneeded cash they hold. Corporations, hedge funds, REITs, foreign entities, money market funds, and banks are the major players in this market, with trillions of dollars of repo outstanding any given day.
Before the Global Financial Crisis, the Federal Reserve had a daily presence in the repo market, lending money or securities to meet the market’s demand. In early 2009, the Fed completely removed itself from the repo market, choosing instead to focus its efforts on outright security purchases (Quantitative Easing), bolstering asset prices during the recession. This regime of free market repo ended abruptly last September when a combination of supply and demand forces launched the repo rate – the cost for cash-borrowers to borrow – to unprecedented highs. The Federal Reserve quickly deployed cash to calm the markets and tamp the repo rate back down to what they deemed an appropriate level.
Since September, the Fed has remained in the market, injecting billions of dollars into overnight and term repo, as well as outright purchasing short-term securities. Since the week of September 18, 2019, the Federal Reserve’s total assets have risen by approximately $472 billion (as of March 3). After the turn of the new year, it appeared the Fed was moving toward leaving the market. Demand pressures that may have caused the September rate spike seemed to have subsided (predicted funding complications around year-end failed to materialize), and no repo operations were planned past April. The coronavirus outbreak now has complicated matters.
The Global Financial Crisis in 2007 to 2008 was exacerbated by irresponsible credit practices, dangerously misunderstood derivatives, and rampant liquidity issues. The global financial system, as we knew it stood on the edge of the proverbial abyss. What we face today with the coronavirus and oil price war is very different, resulting from exogenous shocks to both demand and supply. An earnings shock to an already highly valued market like the US can be detrimental, but not existential. It brings some comfort that the Fed is getting out in front of potential liquidity problems, which could compound market fear going forward if left unattended.
The Federal Reserve’s involvement in the repo market is not without its dangers. Some of the major cash-borrowers in the repo market are hedge funds, REITs, and other asset managers seeking cheap leverage for relative value (long-short) trades. The Fed has introduced a great degree of moral hazard in subsidizing the levered speculative pools of money. Now that the Fed has effectively put a ceiling on the (previously supply/demand-driven) cost of leverage, there’s a potential for the cheap money to be abused on riskier, highly levered trades. Additionally, the Fed balance sheet grows with the new outright security purchases, injecting printed money into the market. If the money flows through the economy, chasing a limited (or even reduced, considering coronavirus-related supply chain breakdowns) number of goods/services, there is potential to see heightened consumer prices. This hike is probably unlikely considering the relatively small amount of purchases compared to previous QE programs.
Unfortunately, the markets today were about as impressed with the massive fed intervention as they were with the President’s speech last night, or the surprise March 3rd announcement of a 0.50 percent decline in the federal funds rate last week to a target range of 1.0 to 1.25 percent. We believe that global markets are waiting for a globally-coordinated, meaningful dose of fiscal stimulus, which would be much more effective in meeting the challenges of a temporary shock to demand, along with slowing momentum of the coronavirus pandemic.
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